I am carrying out some behavioural research on financial market expectations for 2025 and have created a brief survey for people involved in the finance industry to complete.

The survey is very short and simple – it only has 10 questions so should take little more than two minutes of your time. It is also anonymous, so there will be no prizes for good predictions or censure for bad ones!

There is an option to have your responses emailed to you, so this time next year you can review how close your expectations were to reality. I will also follow up with some details on the distribution of market expectations across all respondents early in the New Year.

Thank you for your help.

Financial Market Expectations 2025

It is difficult to go a day without coming across another article explaining US equity exceptionalism. This is unsurprising given that performance has been outstanding both in terms of its magnitude and duration. Yet there is a concerning aspect with many of these pieces – rather than simply explain what might have caused exceptional returns from the US equity market, they almost always make the case for their persistence being inevitable. Whenever investors talk and behave as if the future is both obvious and unavoidable it is sensible to be wary – this time is no different.

Prolonged outperformance is always exceptional

The idea of exceptionalism is not unique to US equities, it is the same argument that is always made about an asset class that has delivered unusually high returns for a sustained period of time. Emerging market equities, dotcom stocks and Japanese equities have all enjoyed spells of being defined in such a way after prolonged and pronounced outperformance. This is driven by the tendency of humans to extrapolate both past returns and the stories which accompany them.

Duration is also an incredibly important factor. The longer such trends persist the harder it becomes to see anything else occurring in the future. Contrarians aren’t broken by the magnitude of poor performance they are broken by its length.

The core point of the exceptionalism claim (for any asset class) is that what has occurred is a secular, permanent feature of markets rather than some temporary phenomenon. Whenever an asset class enjoys exceptional returns for an extended period this argument must be made – it is essential to its continued success. Why? Because as investors are persuaded / compelled / forced to invest more in that asset the only way they can justify it is to make the exceptionalism case.

As a portfolio manager prepares to tell their Investment Committee that they are increasing their allocation to US equities they can hardly produce a PowerPoint slide saying that they are capitulating after significant performance pressure or that they are probably investing at the peak of a cycle. Rather they have to say that US equities are truly exceptional, and they now believe that the advantages are structural and will last in perpetuity.

This is not to say there is nothing exceptional about US equities (more on that later), but simply that the same type of stories justifying the same types of behaviour are always told around asset classes which deliver lengthy spells of uncharacteristically high returns.

If you are ever in doubt about why investors are making the decisions that they are – rest assured that the answer is almost always past performance.

What do we really mean by exceptional?

Asset class exceptionalism is always identified after the fact – but what does it mean to be exceptional?

Although often left undefined, when people talk of exceptionalism they are referring to features that afford an asset class the ability to deliver enduring outperformance. Its causes can be placed into three groups:

Structural: Permanent (or at least very long-term) aspects of an investment that proffer it a return advantage.

Cyclical: Factors that have a variable influence on an asset class’s returns – largely dependent on capital / economic cycle. 

One-off / Singular: Exceptional returns for a period driven by a one-off confluence of variables within a complex system at a particular point in time – these are not permanent nor likely to be repeated.

Exceptional returns are almost always a convergence of these factors, but our tendency is to greatly overstate the role of structural drivers over cyclical phenomena. We are also liable to entirely ignore the influence of one-off factors.

Let’s take one version of the US equity exceptionalism justification. US markets are the most shareholder-friendly in the world, they allow for the emergence of large, significant and successful companies. The US is the market that allows more of the gains of capitalism to go to companies and the individuals that own them. (This may come at the expense of other elements of society, but that is not for this post).

This is a structural argument and one which – in broad terms – is very common. Is it true? Possibly. Does it lead to exceptional stock market returns? Maybe, but few people were saying so in 2010.

But what about the one-off argument? At the start of this exceptional run of performance the US equity market was in the relative doldrums so had undemanding valuations. This was combined with a wave of material technological developments that transformed the economic and financial market landscape and led to the full emergence of a range of staggeringly successful and sizable US listed companies. The financial magnitude of their successes allowed them to make gargantuan investments which further bolstered their dominance.

Here we have a mix of variables – some combination of situational luck and structural circumstance that fostered a pattern of returns that have led to great confidence in ongoing exceptionalism. Yet even if this explanation were to be right (it is not – it will be at best incomplete), it is difficult to ascertain how much of the high returns we have witnessed are to do with something ingrained in US markets and how much is due to the emergence of some exceptional tailwinds.

The answer is always a complex web of factors and nowhere near as simple as any explanation that we might find here.

What does US exceptionalism mean for future returns?

Exceptionalism is justification for past outperformance, but what does it mean for future returns? Continued strong returns is the simple answer, but that is not sufficient. If we ignore the short-term vagaries of sentiment, then claims about equity market exceptionalism must be about superior earnings growth. The central argument of US exceptionalism is that its earnings will grow faster than other markets (let’s ignore starting valuations for the moment). This has certainly been the case over the past decade, but is it set to persist indefinitely?

One of the challenges is where the earnings growth advantage has arisen in recent years – it has been dominated by the ‘Magnificent Seven’ stocks. Although the fundamental performance of these names has been (in aggregate) undeniably outstanding, there is an inherent challenge in the largest companies in the world delivering EPS growth north of 30% per annum if nominal GDP is somewhere around 5%. These two figures are likely to converge over time and I could hazard a guess in which direction. Of course, companies can also claim a greater share of overall growth (even if the rate of economic growth is modest) but this gets increasingly difficult at scale.

This is not to paint a negative outlook for these companies, but rather to make the point that continuing to deliver exceptional results gets harder from here (even ignoring what is already reflected in valuations).

The importance of the Magnificent Seven on the exceptional status of the US equity market also raises an important question. What exactly is it that makes the US exceptional? If it is a broad statement on the overall environment then we should expect equally impressive outcomes from small caps or an equally weighted version of the market. Or is it more that the US is a more fertile environment for the emergence of hyper-successful and sizeable companies? This distinction feels important.

What is the right price for an exceptional market?

At this point of a market cycle simply mentioning valuations can seem somewhat arcane and is often met with a roll of the eyes, yet even exceptionalism should have a price.

One of the comments I often hear is that the US has consistently outperformed despite being expensive ‘forever’, so valuations are clearly meaningless. This is not true – for much of its decade or more of outperformance the US equity market hovered around its long-run average valuation level relative to other global markets, it is only in more recent times where the valuation premium has reached extreme levels.

Saying that valuations are irrelevant makes no sense. They are a terrible timing tool and often an overly simplistic way of assessing return prospects, but that does not make them redundant.

Imagine that US equities come to trade at 100x cycle adjusted earnings and the rest of the world 25x – are valuations still a non-factor for future return expectations? I doubt it. If we believe that there is a return premium for US exceptionalism, we should also be willing to consider what we are comfortable paying for it. If we pay too much, we might not get a premium.

Let’s make it into a very simple question: Over a long-run horizon what earnings growth advantage do we expect a set of US listed companies with global revenue streams to hold over a set of non-US listed companies with global revenue streams?

If we can answer that then we should be able to think about what a reasonable price to pay for that advantage might be. I am not sure what the solution is, but it shouldn’t be that the price we pay doesn’t matter at all.

Everyone already behaves as if US equities are exceptional

One of the puzzling aspects of conversations around the US equity market at the current time is the notion that US exceptionalism is underappreciated. Let’s be clear here – the US equity market represents over 70% of globally equities. The next largest single country is around 5% (Japan).  The fortunes of the majority of investors are inextricably tied to the future performance of the US equity market – both the continued outperformance of the market and investors actively growing their exposure increases this reliance. The size and valuation of the market is reflecting the belief that the US has been exceptional and will continue to be so.

Another behavioural oddity that the current situation of the US equity market is a fascination with minor relative positions over very large absolute positions. In simple terms – an investor with 68% of their portfolio invested in US equities will often seem to worry more about being 2% underweight than the 68% absolute allocation they hold in one market. Over time only one of these things will matter.

A profound challenge with increasing market dominance and concentration is that diversification becomes incredibly difficult. Not only does the outperforming asset (US equities in this instance) passively become a more prominent feature of most portfolios, but the development and reinforcement of the ‘exceptionalism’ narrative means that investors don’t want to be diversified – why would we? We just want to own the exceptional option.

—

Given the current fervour for US equities, this will no doubt be read as a bearish piece on the asset class – it is not – it is and should remain an important part of most portfolios. We should, however, always be cautious of situations where investor narratives and behaviours suggest the future is far more certain than it can possibly be.

–

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

It is that most wonderful time when asset managers publish their expectations for the coming year. As the prospect of reading through the numerous tomes can feel daunting it is worth bearing in mind two important details: 1) Predicting what will happen in financial markets over the next 12 months with any level of consistency is impossible. 2) All of the pieces will (pretty much) say the same as each other, and also in the same way they do every year.  So, as a time saver, here is what they will all say:

– Expect higher volatility: I cannot remember an asset manager ever expecting lower volatility in the future. Volatility brings the allure of opportunities for active management and a reason for the reader to worry (and an implicit reassurance that the writer’s firm can provide a steady hand on the tiller)

– Investors need to be nimble: This is the asset allocators’ version of ‘a stock picker’s market’.

– Investors need to be selective / discerning: A stock picker’s market.

– The traditional approach to portfolio management might not work anymore: Just in case a reader is investing in an old fashioned, unsophisticated way.

– Economic growth will be fine (but with some downside risks): This must be the case because 1: Economic growth is usually solid in any given year and 2: It is not a great idea to tell clients that there is a recession looming.   

– Prevailing performance trends are likely to continue: The safest bet is always to say that what has been working recently will continue to perform well next year (US exceptionalism for 2025). This makes readers feel comfortable and plays on the propensity of markets to trend. It is important, however, to mention something about the potential for a ‘broadening out’ or ‘reversal’ – just in case.

– Alternative asset classes look attractive: Coincidentally, they also happen to have high fees and are difficult to replicate passively.

– A current key structural theme will impact markets: It is important not to be negligent of the critical secular theme that will change everything (AI next year).  

– A current key cyclical trend will impact markets.  It is important not to be negligent of the critical cyclical trend that is on everyone’s mind right now (Trump next year).  

– We should be worried about a loosely-specified tail risk that the market is obsessing over: There is always some tail risk that is concerning investors – it needs to be mentioned even if nobody is quite sure if it is a genuine risk or what to do about it (fiscal sustainability next year).

– Equities will perform well: This is both likely to be true in any given year and avoids panicking readers.

These annual documents are generally a good, tangible reminder that we are hopeless at forecasting and that financial markets are always a rotating cast of salient topics that feel urgent in the moment but have little predictable bearing on long-term outcomes.

To the extent that short-term issues matter at all, it will be the ones that nobody is expecting that will have a significant market impact.

If read for what they are – a gentle sales pitch with some interesting financial market observations – they are harmless enough, particularly if they, somewhat inadvertently, encourage readers to stay invested over the long-term. But we certainly don’t need to be acting on them and rest assured nobody will remember anything that is being foretold now in 12 months’ time.

—

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

Morningstar recently published a study of the thematic fund universe, which showed that over the past five years assets had grown from $269bn to $562bn.[i] While through certain lenses this might be seen as a success story, it is bad news for investors. Over a 15-year period only 9% of funds in this space have survived and outperformed. Although that number may seem troublingly low, the reality is likely to be even worse.

Unfortunately a 91% failure rate is unlikely to dampen our enthusiasm for thematic funds because when presented with such information we will almost inevitably believe that we can be in the 9%.

If this overconfidence isn’t damaging enough, it is probable that the 9% number overstates our chances of a positive outcome from investing in a thematic fund. Another piece of Morningstar research from earlier this year compared time weighted and money weighted fund returns in order to observe the impact of the timing of investor cash flows – the so called ‘behaviour gap’.[ii] The two groups of funds that suffered the largest negative investor return gaps were ‘Non-Traditional Equity’ and ‘Sector Equity’ – the areas in which we would expect most thematic strategies to reside.  

This is unsurprising – thematic funds tend to exhibit high volatility and be more prone to bouts of exuberant speculation and painful comedowns – and it means that the 9% figure might be overly optimistic. Not only are there apparent structural issues with thematic funds, but they also seem to encourage some of our worst behaviours.

So, is there something inherently wrong with investing based on a particular theme or unified idea? Not necessarily, it is more that the majority of thematic funds tend to share a certain set of characteristics:

– Compelling, high growth narrative (most thematic funds are growth-biased).

– High fees.

– Unusually strong past performance from the area in focus. 

– Rich valuations of target stocks.

– Concentrated portfolio.

If I had to draw up a list of the top five things fund investors should avoid – this would pretty much cover it, and in thematic funds we often have them all wrapped up in one neat package for our delectation.

This is a classic case of the industry selling things that are good for them and bad for clients. Asset managers know that we are inextricably drawn towards powerful stories and strong past performance – thematic funds are designed to exploit this. They are funds with in-built marketing. It is easy for firms to launch lots (which they do) and hope that some stick; that most of them fail is of no great concern.

As thematic funds are typically launched in areas into which capital has flooded and driven up valuations, would it be possible to do the reverse – launch a strategy with a unified theme in an unloved area from which capital was being withdrawn? It would, and it may have a greater chance of success, but there is one small problem – nobody would buy it.

Investing in a thematic fund is an active investment decision – whether it is a pure active strategy or replicating a theme-driven index – it is also one with terribly poor odds of success. If we cannot resist the powerful urge to invest, we need to ensure that we size our position so that our portfolios can withstand the likely disappointment.

---

[i] Navigating the Global Thematic Fund Landscape | Morningstar

[ii] Mind the Gap 2024: A Report on Investor Returns in the US | Morningstar

—

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

Back when I started my career in 2004, I remember that virtually every client account I looked at had tiny allocations to technology-oriented equity funds. I was initially puzzled by this before realising that these now inconsequential holdings were once significant but had been eviscerated in the denouement of the Dot-Com bubble. Looking back on such periods of exuberance and collapse it is easy to think that avoiding similar situations is straightforward. This could not be further from the truth – although the underlying stories may change the behaviours do not. Speculative bubbles are an inherent feature of financial markets. The key question is where are they most likely to occur?

Let’s start by defining terms. Robert Shiller – something of an expert in this field – defines a bubble as such:

“A situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors … despite doubts about the real value of an investment”.

I would add to this that bubbles typically involve some extreme dislocation between the pricing of an asset and any reasonable fundamental valuation of it. The only exception to this is where it is impossible to value the asset (more on this later).

There are four aspects that are key in the formation of a bubble: A compelling narrative, strong performance, powerful incentives and social proof. Narratives provide the foundation and ongoing support for a bubble, high returns corroborate the story, financial incentives are the reason why people become involved at all and social proof encourages action (we care deeply about what other people are doing.) These four elements create a virtuous (or vicious) circle as they feed upon each other, leading to dramatic price movements. 

Although predicting when a bubble may occur is likely a fool’s errand there are inevitably factors that increase the probability that a certain asset may be susceptible to such speculative activity. 

What are the features of an asset or the themes supporting it that increase the risk of a bubble?

1) True and simple stories: Although the underlying narrative supporting a bubble does not have to be true (sometimes they can be nonsense) the most dangerous are those which are supported by a valid and simple story. This allows investors in the bubble to answer easy questions such as (in the case of the Dot-Com bubble): Will the internet change our lives? Rather than more difficult ones such as: Which companies will benefit and what is already reflected in valuation? There is far more money to be lost when a story used to justify an investment bubble is true. 

2) Transformative stories: For bubbles to successfully emerge it needs to be easy for investors to disregard traditional approaches to fundamental investment valuation. It pays therefore for the narrative underpinning the bubble to be about a seismic change, which makes it easy to ignore the warnings of naysayers as their anachronistic methods simply do not incorporate the revolution that is taking place. 

3) Everyday impact: The most powerful bubbles draw in incredibly wide participation, even from individuals who would not normally make active investment decisions. The more that the story supporting a bubble in an asset relates to how we experience everyday life, the more people that are likely to become involved. If we can see and experience the story unfolding then we are more likely to buy into it.

4) Unquantifiable scale: Big bubbles need a big story. If there are obvious limits to growth then it puts a lid on speculation. A genuine bubble needs an asset where the transformation taking place means that it is difficult to limit the upside potential (in theory).

5) Difficult to value: Although most bubbles involve a yawning disconnect between the price of an asset and any prudent approach to valuation, the most significant bubbles can occur in assets that are either difficult or impossible to value. While equity market bubbles can be extreme at some point there will be a gravitational pull from fundamental realities of the asset class, but assets which are impossible to value because they have no cash flows – such as gold and cryptocurrencies – are perfect. If you cannot value an asset, who is to say what the upside could be?

This distinction leaves us with two types of assets: fundamental assets and belief assets. Fundamental assets have cash flows which means that (in theory at least) we can value it in some sensible fashion. By contrast, belief assets have no practical means of valuation, so they are priced based on what others are willing to pay. The easiest way to judge where an asset sits based on this delineation is to ask yourself – if an asset’s price was up 100% or down 50% tomorrow (other things equal) would that change my view? For fundamental assets this should dramatically alter its attractiveness, but for belief assets large price moves don’t really change anything apart from sentiment. This feature gives them a huge potential range of outcomes (from staggeringly good to disastrous) – ideal for bubble formation.

The more that an asset possesses these five features, the greater the propensity is for bubbles to develop. It is not simply about the asset, however. As Shiller’s quote highlighted, speculative bubbles are formed by people and their behaviour. The makeup of market participants matters, in the simplest of terms we can think of three groups involved in a bubble: Believers, Chasers and Luddites:

Believers: This group have fully adopted the story underpinning the bubble and approach it with almost religious fervour. Rather than being an investment view it often becomes part of their identity. They will never sell, never criticise and are able to justify any valuation. Their ardent belief either comes from developing a genuine confidence or faith in the asset and its supporting narrative, or because their financial incentives have become inextricably entwined with the continuation of the bubble. 

Chasers: This group are agnostic on the story and its validity – they just care about the price movements. They buy into a bubble because performance is strong. Like believers they have little regard for valuation, but are not wedded to the asset – they will own it while it is going up because it is in their financial interest to do so. A classic member of this group are asset managers launching products based around an emerging bubble asset, they don’t believe in it – they want to make money from it. Being a Chaser can be an explicit strategy but often it is simply the strength of performance from the bubble asset that draws them in for fear of missing out or maybe losing their job. Although this is the largest group, few will admit to being a member of it – momentum investing has a bad reputation, unless you are a quant.

Luddites: This group may believe in the story supporting the asset and almost certainly consider it to be grossly overvalued. They will inevitably endure poor performance as the bubble develops and be regarded as stubborn and out of touch. Professional investors in this group will risk dwindling assets and eventually their careers.

Both the relative size and movement of these groups will be crucial to bubble formation. While Believers are important in spreading the supporting stories they will be in the minority (although their flock will increase the more extreme the performance). The size of the Luddite group will shrink as the bubble grows as some capitulate to become Chasers and others give up.

It is the Chasers, however, that are most important. This will be the largest group and dictate both the size and persistence of the bubble. Their eventual exit from the asset will also precipitate its end.  

—-

Although difficult to validate, my base case would be that the potential for bubbles or prolonged periods of very extreme asset class performance is greater than ever before. Increasing connectedness through the rise of social media makes for easier amplification and transmission of stories, while I would also argue that investor time horizons are contracting – making us more prone to chase the performance of whatever is working. 

However we approach speculative investment bubbles – whether we choose to embrace them, chase them or ignore them – their emergence presents profound risks both in terms of the asset in question and our behavioural response to it. As a bubble inflates and the story becomes evermore persuasive, the increasing cost of missing out is likely to overwhelm the increasing risk of disastrous losses. 

–

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US). 

After reading my 641^st article confidently explaining ‘what Trump’s election victory means for markets’; I was reassured that there seemed to be a broad consensus on its implications. This allowed me to invoke one of Bob Farrell’s ten investing rules: “When all the experts and forecasts agree – something else is going to happen”. While the clarity provided by the election result may have provided some relief, it should not embolden us into believing we know what will occur next, because the truth is that we have no idea.

No matter how uncertain the outcome of a particular event is, what we know with absolute certainty is that when the results are in we will discuss them as if they were an inevitability. And so it is with the US election, where in reading the post-mortems of Trump’s victory we are led to wonder why the Democrats contended the election at all given how obvious its conclusion was.

From an investment perspective it is, however, critical to remember that the result was – for many – considered to be the flip of a coin with very few people willing to take a high conviction view on who the victor would be. This is important because it brings into sharp contrast an odd dynamic whereby most market participants were (rightly) unwilling to predict the outcome of a one-shot, binary election result around which there was a huge amount of data and information, but are now comfortable telling us what the longer term market and economic consequences of it will be. If we can’t answer the easier question with confidence, let’s not try answering the harder one that is immeasurably more complex.

Another favourite investor activity following an event such an election is to look at the immediate financial market reaction, hoping it will provide us with a sure guide as to what lies ahead in the coming months and years. It would be fantastic if this were the case, but it isn’t. When it became clear that Trump would regain the Presidency were investors hastily updating their inflation assumptions and quickly reworking their equity DCF models, or simply trading based on how they expected other investors to trade? Almost certainly the latter.

Market activity around such periods is both self-referential and self-reinforcing. Market participants decide how they will react prior to the event (in the most recent case the so-called ‘Trump trade’) and then react in that way immediately after. It doesn’t provide us with any longer-term fundamental insights, as much as we might want it to.

As markets were busy digesting the results of the 2024 election I looked back at the initial reaction to Trump’s 2016 win. In the two weeks that followed, the ten-year treasury yield rose, as did the dollar index, while in US equity markets financials, industrials and energy outperformed the wider market. And what happened over the full four-year term? Treasury yields fell, the dollar index weakened and all three of the aforementioned equity sectors underperformed the index.  

If the market was really telling us something immediately after that election, why was it wrong?

There are four critical reasons that make taking confident views about election results is so dangerous for investors:

– We don’t know what they will do: Although we can surmise and hypothesise, we have no certainty around what decisions a new administration might make.

– We don’t know what the consequences will be: Even if we did know what decisions would be taken, trying to understand the financial market consequences is close to impossible given its sheer complexity and deeply interwoven nature.

– We don’t know how much it will matter: Even if we knew what a new government would do and had some idea of the broader implications, it is still difficult to judge how to weight it relative to other factors. Is the occupant of the White House more important to equity market performance than how AI / tech develops from here? There are many, many variables that will matter and some will almost certainly be more consequential.  

– Other stuff will happen: Perhaps the most essential challenge for investors is that perennially frustrating problem of other things happening, things that we are not even considering today. These are likely to overwhelm whatever we are thinking about right now.  

—

Investors abhor uncertainty and we are always looking for clues to how the future will unfold. Unfortunately, unpredictability is an ingrained feature of financial markets, not something that can be solved, and it is dangerous to believe it can be. More often than not admitting that we don’t know is the right answer and the one likely to lead to better investment outcomes over the long-run.   

–

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US). 

The week of the US election is the perfect environment for investors to make unfathomably difficult forecasts about financial markets with entirely unjustifiable levels of confidence. These could be about anything from identifying which equity market sectors might benefit from a particular outcome to forewarning a rout in US treasuries. Making decisions based on such prognostications is a wretched idea. This is not just because of the difficulty inherent in any given prediction, but because for it to be worthwhile investors have to keep getting such calls correct over and over again. The chances of this are slim and the downside severe.

When considering the type of investment decisions we want to make we need to ask ourselves not only about the likelihood of being right about a specific circumstance, but of being consistently more right than wrong in similar situations through time.

This is the challenge that resides at the heart of making bold macro calls or attempting to aggressively time financial market movements. While we might be fortunate with a view in a certain instance – how likely is it that we will overcome the odds and keep doing it?

No investment decision is ever made in isolation. We always have to consider: what comes next? Let’s imagine that we forecast a recession and an equity bear market – even if we are right, will we continue to be so? How deep will the downturn be? When will it end? What will the recovery be like? Each situation has its own unique set of complexities and uncertainties, which means that even if we strike it lucky once, we must repeatedly answer incredibly difficult questions. It is never one and done.

It is not even sufficient to be more right than wrong. We also need to understand the cost of being wrong, and our ability to recover from it. One mistaken call on an equity market downturn or a surge in inflation could prove irrecoverable. Investors making regular high consequence, high complexity decisions are playing Russian roulette.

This is exactly what we frequently experience with prominent hedge funds managers. They are given the limelight and earn astronomical performance fees (no clawbacks) for getting one big decision right. The problems then arise when they have to repeat the trick.  

If we are to consistently engage in low probability investment activities then we will either fail quickly or slowly. Slowly – if we are circumspect then over time the poor odds of what we are doing will catch-up with us. Quickly – if we take enough high consequence bets then one of them will end in disaster.

The interminable noise of weeks such as these gives entirely the wrong impression of what investing is and should be about for most people. Getting macro and market calls right is hard once, doing it repeatedly is close to impossible. Fortunately most of us don’t even need to try.

—

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

Which modern US presidential election has had the most significant impact on long-run asset class returns? I have no clue, but I am going to confidently tell you how financial markets will react to the upcoming one. Major events matter a great deal to investors even though history tells us that it is impossibly difficult to foresee their consequences, or indeed know whether they will matter at all over the long-term.

Ignorance would be bliss

The most obvious reason that noteworthy events, like presidential elections, are so diverting is that they are inescapable. We cannot help but have our attention drawn to them, and we consistently overweight the significance of things that are salient and available – that which is happening right in front of our eyes. To make matters more difficult, events like elections can have great importance in certain aspects of our lives, but not have much bearing on the long-term success of our investments. It is incredibly difficult to disentangle this – when an issue is relevant, we cannot help but think it is relevant everywhere and to everything.

It is also almost impossible for an investor to remain indifferent to a topic over which the asset management industry is obsessing. The fact that everyone has a forthright opinion on a subject bestows a significance upon it. We can join the party, or risk appearing negligent.

The threat of being labelled as inattentive to a profoundly consequential occurrence is exacerbated by the fact that – over the short-term – events like presidential elections will have an impact on financial markets. Many investors are involved in playing a game of predicting how other investors will react to a certain development: If x wins the election, then y sector will benefit – this type of behaviour is self-perpetuating. Markets move on events because investors expect markets to move on events. Although engaging in such speculative activity is unlikely to be beneficial, it does make doing nothing challenging – “you said elections were irrelevant, but look how markets have reacted”.

During such times it is easy to do things that are positive for how we are perceived, but negative for what we are trying to achieve.

Even if we are resolute enough to ignore the noisy, near-term ramifications of high-profile market events, surely they sometimes have longer-term consequences? It is possible, but requires us to predict profound structural changes in financial markets or economic conditions. It is far from easy to link an isolated past event to subsequent market performance – believing that we can do it for the future seems fanciful.

Complex problems

When we consider major events it is inevitably in a deterministic fashion. We believe that an event will precipitate a specific reaction, but that is not how complex systems work. They are chaotic and unpredictable. The result of one binary event (such as an election) could set us off on a million different paths, based on the disordered interactions of an incalculable number of variables. A deterministic approach makes us feel comfortable amidst substantial uncertainty, but it is in no way a reflection of reality. Investors might want it to be one way, but it is the other.

The best evidence of the challenge of making predictions around the financial market implications of events is how little time is spent reflecting on our previous forecasts. When a pundit spells out the consequences of the coming election result, how often do they inform us of their prior prescience around historic elections? On average, never. This is not just because they were probably wrong and that might inhibit our confidence in them, but because when we look back we will see quite how messy everything that followed was and how difficult it is to draw clear lines of causality. The US election is unlikely to be an epochal event that fundamentally changes the long-term financial market outlook (certainly not in a predictable way).

A common approach to simplifying the logic around how financial markets might behave around an election is to look at past instances of the same event. The problem of this – particularly when they are relatively rare – is that the sample size is inescapably miniscule, and each instance is influenced by a specific set of variables that were relevant only at that time. Confidently drawing inferences from such analysis is fraught with danger.     

Managing event risk

If engaging in speculation and prediction around the US election is unlikely to be prudent, what should investors do – just ignore it? Yes and no. Most investors with sensibly diversified portfolios haven’t really ignored this event or any others, they have instead used the principles of diversification when building their portfolios to reflect the fact that the future is inherently uncertain (and that includes event risk). A well-diversified portfolio is one which is robust to a range of different outcomes in financial markets – sufficiently resilient in the short-term to meet long-term goals. Unless we have a high conviction that the election materially changes the risk and return characteristics of key asset classes, our best approach is to do nothing and stay diversified.

When event risk is on the horizon, investors often gain comfort from running stress tests and scenario analysis on their portfolios, this can be problematic. As the saying (sort of) goes: all models are wrong, some are also useless. While it can – if framed with the appropriate context and caveats – be very helpful to understand the potential range of outcomes faced by a portfolio; tests that attempt to specify how asset classes will behave following a particular event are inevitably founded upon unrealistic and overconfident assumptions about the future. They can give us a false sense of certainty and should be handled with the utmost scepticism.

A stress test that would be beneficial for investors would be one that warns us of the type of poor decisions we are liable to make when under stress. These are the stresses that will have a predictable impact on portfolio outcomes.

—
Significant events such as the US election present an acute challenge for investors. Sticking to our plans and admitting the limits to our knowledge amidst the maelstrom of pontification and prediction can seem almost impossible. Long-term, well-diversified investors should not despair, however, with a little fortitude it will pass away soon enough.

Until the next event.   

–

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

I recently came across a statement made by Warren Buffett in a 1965 letter to his Partnership where he mentioned group decision making: “My perhaps jaundiced view is that it is close to impossible for outstanding investment management to come from a group of any size with all parties really participating in decisions.” This made me reflect on the fact that the overwhelming majority of the literature and research around behaviour and decision making produced in recent decades has been about how individuals make choices, but in virtually every walk of life – politics, business, family and investing – decisions are frequently made by groups of people. Despite this little time appears to be spent seeking to understand how groups function. This is a severe oversight. If we thought individual choice was confusing and problematic, just wait until we start putting people together.

It is important to define what a group decision actually is. For me there are two key features:

1) People ostensibly working together to reach a decision.

2) More than one person has the ability to materially influence (implicitly or explicitly) the decision made.

A group decision does not have to be a situation where there are 11 people sitting on a committee and each holds a vote, in fact many collective decisions look like individual choices in that a single person makes the ultimate call, but are actually the outcome of group interaction and influence.

Why are most decisions made – in some form – by a group of people? There are two reasons. First is a desire to combine experience and expertise. In theory, better decisions should be made if there is an ability to access higher quality information and inputs. Second because there is a need to represent multiple stakeholders. Where a decision impacts different groups, there is often a requirement to provide an appropriate voice to those parties.  The makeup of most boards and committees should at least attempt to meet these two criteria.

While these both seem laudable aims, they can create profound decision-making problems if not handled considerately (and might still do even if they are). The investment management industry is overrun with implicit and explicit group decision making, but I have barely ever heard anyone talk coherently about how groups have been brought together. Yes, in recent years lip service has frequently been paid to the notion of cognitive diversity, but I have severe doubts that many people using the term have a clear idea of what it means and its implications.

Imagine involving a group of people in a decision all of whom have different personalities, incentives and beliefs, and expecting that to result in a coherent outcome. It seems entirely non-sensical, but this is exactly what occurs in most group decision making scenarios.

It is not that the construction of decision-making groups is random – there is generally some credible reason as to why people become involved in a decision – it is just that there is an inescapable complacency about how or why the interactions of the group will impact the type of choices being made. This almost inevitably leads to unintended consequences and undesirable outcomes.

There are several critical issues to consider when trying to avoid the major challenges of group decisions:

Goals and incentives:  The essential condition for effective group decision making is shared goals and aligned incentives. If the individuals with influence over a choice are not attempting to achieve the same objective then any decision it makes is likely to be greatly compromised. Organisations where group decisions take place are typically incredibly complacent about this, assuming that ‘of course’ all people involved have the same objectives. This is rarely the case, usually because the personal incentives of individuals are wildly misaligned.

The critical question to ask is – what is the primary incentive / aim of an individual involved in this decision? To take a heavily stylised example: Imagine there is a portfolio manager and a risk manager in a group involved in making an investment recommendation. The portfolio manager’s primary aim it to maximise return, the risk manager’s is to avoid disaster. These are both rational positions to take for them as individuals but it is very unlikely to lead to rational decisions at a group level – they have skin in different games. Now imagine it is not two people involved in an investment decision, but 17 all with somewhat contrasting motivations.

This is not to say that individuals with different specialisms and areas of focus cannot be involved in an effective group decision, it is just that for it to work they have to have their incentives aligned. Most groups involve a collection of people optimising for different things, resulting in sub-optimal results.

Philosophy and values: Consistent goals are integral to effective group decision making, but almost as important is shared philosophy and values. This does not mean that individuals within a collective have to think in the same way or attempt to tackle each problem in an identical fashion, but they must hold a set of common beliefs about the best way to reach their objectives. Group members can challenge each other without challenging their identity.

Decision making groups with a shared philosophy can discuss and debate the nuances of how best to apply that set of beliefs to the problem that they are trying to solve. Groups with philosophical differences will forever be trapped in unresolvable debates, often making little progress.

Accountability sinks: One of the primary risks of group decision making is the creation of what economist Dan Davies calls “accountability sinks”. This is where organisations remove individual accountability for decisions and instead place it into amorphous groups, policies and procedures. This creates a situation where nobody is to blame for anything – the system has responsibility. This can be quite attractive for people because being held to account is often unappealing, but it can lead to bad decisions, the complete removal of agency and chronic inflexibility.  The atrocious Horizon IT scandal that recently engulfed the British Post Office, is almost inevitably an extreme example of horrendous group / system-led decision making.  

Decisions can be categorised on a spectrum from those that feature individual accountability to those where there is no obvious accountability:

– Individual (Single accountability)
– Group (Shared accountability)
– Multiple Groups (Vague accountability)
– System (No accountability)

This is not to say that individual, sole responsibility decision making is always optimal, but we must be aware of the consequences of the shifting accountability structure that occurs as the number of people involved in a decision increases. Individual behaviour alters dramatically if we have 100% responsibility, compared to no ultimate responsibility.

Implicit group decisions: Another major accountability problem arises when decisions appear to have individual accountability but are actually heavily impacted or constrained by others. Similar to accountability sinks, this can be appealing for most group members because they can exert material influence without any consequence for their actions. It is not, however, appealing for the individual who is deemed to be the decision maker.  Davies, again, has a simple test for whether someone deserves to be accountable:  

“The fundamental law of accountability, the extent to which you are able to change a decision is precisely the extent to which you can be held accountability for it, and vice-versa”

It is quite common for individuals (or other groups) to hold the ability to materially alter a decision while seemingly being a great distance from any accountability for it. This typically occurs when people are able to apply constraints to a decision; here the accountable decision maker appears to have full responsibility for the ultimate course of action taken, but their set of options has already been greatly reduced by others.

This type of scenario often precedes the formation of accountability sinks – as when the accountable individual realises that they hold little agency they baulk at this arrangement, and prefer something more anonymous.

When assessing a group decision structure, it is vital to look at everyone with involvement and ask which individuals (or groups) have the power to significantly shape the ultimate choices being made.   

Accountability shields: A less common structure for a group decision is an accountability shield. In this situation, one dominant and influential party has an overwhelming power to dictate decision making. They are, however, reticent to bear responsibility for potentially negative outcomes and therefore create what appears like a group / committee / board structure to insulate them from full accountability. This creates an attractive asymmetry for the individual who holds power. The groups involved are functionally pointless, bar providing some protection in the event of disappointing results.

Groupthink: Although most of us never seriously consider the implications of group decision making, there is one topic that is always mentioned if the subject is raised – groupthink. This is a situation where a collective makes a poor decision because there is not enough challenge or critique from within the group. While this can be a valid concern, the issue is nuanced. Certain elements which may be classed as groupthink – such as shared ethos, values and principles – are an integral part of a cohesive group structure. It is, however, crucial that a broadly shared philosophy is allied with psychological safety, freedom of expression and a diverse set of skills. For harmonious groups to be effective they must be able to allow new ideas to permeate and accept that they can be wrong.

Groupthink is undoubtedly an issue worthy of serious consideration, but attempting to mitigate it by putting together a collection of ideologically opposed individuals with conflicting incentives is a bad idea.

The behavioural melting pot: Individual decision making is chaotic and idiosyncratic. Group decision making takes all of our personal foibles, puts them into a pot and stirs. It is impossible to understand how the choices made by groups will react to this confluence. As much as we might try to refine and reshape a group to improve its decision-making capabilities, a significant element will remain the wholly unpredictable noise that emerges from a convergence of personal behavioural biases.

Power dynamics: Power is perhaps only second to incentives in understanding what drives human behaviour. If we have a clear understanding of individual incentives and the power dynamic at play in any given situation, we can get a long way to understanding the choices that are likely to be made. Talking and thinking about how power impacts the workings of a group is unfortunately something few people are comfortable discussing, probably because we are reticent to upset the people that wield the power. In large organisations power doesn’t have to be held by individuals, it can be held by the system – a structure of policies, procedures and groups can wield an overwhelming but largely silent power.

Group size: When attention is given to group decision making, a common question pertains to the appropriate size of the group – what is the most effective number of participants? There is no right or simple answer here – it depends on the type of decision being made. One overlooked consideration is seeking to understand exactly how large a decision-making group is, which in many cases we probably don’t really know. Returning to my original criteria – we need to identify the people who both have input and can influence a decision. That is our real group size, which could be very different to the number of people sitting on a formal committee or board.

A large group size does have benefits as it should bring with it a greater diversity of skill and provide a voice to multiple stakeholders (where relevant). This notion only holds, however, if some deliberate thought is given to its construction. The main issue with sizeable groups is that most of the problems discussed in this piece become more likely and more pernicious the larger they get.

Group size and composition have a huge bearing on the type and quality of decisions made, but we pay barely any meaningful attention to them.

What defines a group that makes high quality decisions?

The sheer complexity of group decision making may make it seem like a problem that is not even worth confronting, but given how influential these dynamics are to most of the choices we make it is not something that we can continue to ignore. As always, the best way to deal with something that appears unfathomably complicated is to apply some simplicity to it. To my mind, there are three characteristics that a group needs to possess to have a chance of making smart choices:

1) Aligned goals and incentives:  A high-quality decision-making group must have shared goals – they have to be trying to achieve the same thing.  Companies tend to get this spectacularly wrong by creating vague purpose statements that will have no meaningful impact on anyone’s behaviour. Shared group goals are derived from shared individual incentives. Do good and bad outcomes look the same for each member of the group?

2) Shared philosophy and values: A consistent set of values held by the group members is essential for high quality decisions. This doesn’t mean that they need to agree on every aspect of a task or problem, but rather there are no major philosophical gaps between individuals. If there are then the group is likely to fall at the first hurdle. Shared principles should be the foundation of any effective group.  

3) Complementary skills: The key reason for having a group decide is that it grants input and influence to individuals with distinct and complementary skillsets. The more complex the task, the more useful this can be. The key challenge here is that people fall into what football fans might think of as the ‘Paris Saint-Germain trap’ (or maybe the English national team) where we believe that an effective group is simply a collection of the most ‘talented’ individuals. This approach almost always ends badly as it disregards the vital notion that a strong team combines different characters, skills and expertise to meet a particular goal. Haphazardly combining some good individual decision makers will not create an effective decision-making group.

—

I often find myself frustrated at the lack of thought given to individual decision making, but this pales into comparison with the neglect of group decisions. The majority of the choices that we make (particularly in a professional context) are made by some form of collective, but we spend incredibly little time considering how groups function and the type of choices they are liable to make. It is undoubtedly a messy and intricate topic, but most of us don’t even try to get the basics right. Instead groups risk being blighted by murky accountability, misaligned incentives, opacity and compromise – not the ideal setup for sound decision making.

–

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

What will the Fed do next? How will conflict in the Middle East impact the oil price? What does a new bout of stimulus mean for the Chinese Equity market? Is the US economy heading into a recession or reflation? Investors are trapped in a vortex of noise. We are compelled to engage with and react to a rotating cast of inescapably prominent and impossibly complex issues. This constant state of flux is the lifeblood of the investment industry but poison for clients. For most investors 99%, of what we see, hear and feel in financial markets is not just irrelevant to what we are trying to achieve, it actively makes it harder to make good decisions and attain our goals. Why is noise so ubiquitous and what can we do about it?

Critical to the success of any investor is the ability to cancel out the noise that surrounds us and focus on the elements that will have a material influence on our outcomes. Given the sheer complexity and chaos inherent in financial markets this can seem like an impossible task – how can we figure out what is significant?

There are two key criteria we can apply to help us identify harmful noise in financial markets (which is the vast majority of what we encounter). For any issue or event, we should ask two questions:

– Does it matter?

– Is it knowable?

Unless we can answer both in the affirmative, we can classify it as unhelpful noise.

Let’s take each in turn:

– Does it matter? Here we are seeking to understand whether the subject we are focusing on will actually matter to what we are trying to achieve. Let’s assume I have a 20-year investment horizon, will the next decision by the Fed have any obvious impact on my investment goals? Absolutely not. The same can be said for whatever geopolitical issue is the focus of our attention at any given point in time. If something is likely to have either no effect or a random influence on us meeting our investment objectives, then it is just noise. Spending time thinking about it is likely to leave us worse off. 

Even if something does matter – we are confident that some variable or topic will have a material impact on our investments over the time horizons that matter to us – it can still be noise, because it also must be knowable.

– Is it knowable? Being confident that something actually matters is a pretty high hurdle for investment information, but even that is not sufficient. For it not to be noise, it must be knowable or predictable. Why? Well, let’s say I was certain that the near-term decisions of the Fed or the latest geopolitical issue would have an impact on meeting my investment objectives – this is only meaningful if I know or can predict the outcome of these things. I need to know both that the Fed decision matters and believe that I can predict it, otherwise, what am I going to do about it?

If that isn’t tough enough, there is another problem. We often need to know two things – both what is going to happen and how it will impact financial markets. Many wonderful (lucky) predictions about a particular event have been rendered worthless because someone got the second part wrong. Forecasting any future occurrence is usually a herculean task, adding on a prediction of how it will then influence something else (alongside all the other unforeseeable things that might also impact it) is getting us pretty close to impossible.

So, how can we tell what matters and what is knowable? Well, we can apply some simple tests.

Does it matter?

Test: If I had a crystal ball and knew something would occur in advance, would it change my investment decision making?

This is a useful test for long-term investors because most things really should not influence our choices. There is a danger, however, of being overconfident and believing that certain pieces of information will move markets in an obvious way. Imagine having some foresight of 2020 ‘Covid’ economic data and making investment decisions based on that – it probably would have ended badly.

Is it knowable?

Test: Is the information already known or is there evidence that people can accurately predict it?

The most obvious piece of information that is in some way knowable is the valuation of an asset. For example, when bond yields were close to zero we didn’t need to make predictions about future returns being low – we knew this. Unfortunately, most financial market relevant activity isn’t knowable, it is instead reliant on making bold predictions about the future, which in complex adaptive systems is quite the ask.

Bringing these aspects together creates a simple framework for addressing the issue of noise in financial markets and the many problems it causes investors: 

Does it matter?	Is it knowable?	What to do about it?
Yes	Yes	Use the information
Yes	No	Diversify
No	No	Ignore

When people talk about current hot topics in financial markets – usually in wildly overconfident ways – we should be trying to apply this framework before anything else. Ask does the thing being discussed have any relevance based on my objectives and horizon, and if it does, is it reasonable to believe that it is in anyway knowable or predictable? The vast majority of things we can ignore, some things matter but are unpredictable so we diversify our portfolios, and a select few things really matter and should inform the investment decisions we make.

It is fair to say that what matters depends on the individual investor and what they are trying to achieve. So, for short-term traders many more events and occurrences will seem to matter because they are trying to judge near-term changes in sentiment. It is expected that they will interact with the market more than those with a longer horizon. The problem for investors taking such short-run perspectives is that most of the variables that might matter for them are not predictable in any reasonable or consistent way.

Using this framework leaves something of a puzzle, however. Most investors have long-term objectives, yet almost everyone seems to be obsessed with perpetuating short-term noise – constantly talking about things that don’t matter and / or are unknown and unpredictable. What causes such a dynamic? There are many, many factors at play, but here are a few ideas:

We want to reduce uncertainty: As humans we abhor uncertainty, and there are few things more uncertain than short-term financial market fluctuations. Engaging with what is happening and listening to people who confidently explain it (and predict how it will develop) is incredibly comforting. The sense of security it gives us is entirely false, but it feels real.   

We react to what is in front of us: Even if we try to avoid it, we are surrounded by news of what is unfolding right now and cannot help but think that what is happening in the moment is more important than anything else. 

We want to sound smart:  Talking about financial markets makes us sound smart. We can quite easily be wrong about how every major financial market event unfolds yet still sound credible and intelligent whilst doing it. The alternative is to say “I don’t know” or “it probably doesn’t matter” and that doesn’t do wonders for our conversations or career.

We don’t want to look negligent: One of the real challenges faced when trying not to engage with market noise, is that there will always be some events that will have an impact and matter (particularly in the short-run). We won’t know what these are beforehand, but after they occur everyone will act as if they were obvious and inevitable. We cannot risk looking negligent, so it is safer to treat everything as if it might be vital.

We avoid feedback: Does anybody genuinely keep track of the views they have on market events and short-term market moves? Almost certainly not. Everyone knows why this is, but it doesn’t matter because everyone carries on in the same fashion. ‘I was wrong yesterday and the day before that, but I will be right tomorrow.’

We focus on what matters to others: Unfortunately, it is not the things that matter to our long-term outcomes that are most important, but what other people think matters. If everyone else in the industry treats certain events or issues with the utmost significance, it is almost impossible to be an outlier. The industry acts as if these things are important, so clients think they are important, and it is rational to conform.

We want to sell something: Everything always in the end comes down to incentives. Noise, news flow and the conveyor belt of market events grease the wheels of almost everything that happens in the industry. It is in the interests of everyone to join in (apart from the clients).

We are bored: The willingness of investors to engage with market noise always reminds me of a social psychology experiment where participants were left alone in a room for fifteen minutes. They could either sit and think, or press a button that would give them an electric shock. 67% of men chose to electrocute themselves. Long-term investing is usually dull, embracing the noise of financial markets might be painful, but at least it stops us being bored.

—

I often wonder whether the majority of people involved in the investment industry know that much of what is discussed and debated on a day-to-day basis is often irrelevant and almost always unpredictable, and just play along with the game, or if they actually believe that they stand apart from everyone else in their ability to make sense of the cacophony. Whatever the case, noise is a real problem for most investors and one that can lead to poor long-term outcomes unless we find ways to drown it out.

The next time you get drawn into a conversation about the latest market event try stopping yourself and first asking – does this matter and is it knowable? The answer will usually be no. 

–

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).